Uncertain Times - Europe Leads Progress to Sustainability Reporting
Financial Reporting Brief: April 2022
- Uncertain Times - Europe Leads Progress to Sustainability Reporting
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Often referred to as the ‘invisible war’ to fight, COVID-19 truly rocked the World and just as we appear to be on the path to recovery from its worst impacts, a new ‘visible war’ is very much upon us. While we may be removed by distance from the brutal atrocities of the Ukraine, it very much occupies a large space in our minds and in our hearts. It is also a major contributor to alarming economic and inflationary pressures, the likes of which have not been with us for 40 years or more.
Those of us in the world of corporate reporting face additional challenges in dealing with developing a coherent message to be reported to investors and other stakeholders. There is an even greater demand for reliable and transparent reporting in these challenging and uncertain times. Our March article in the Financial Reporting Brief (FRB) series highlighted the fundamental importance in these uncertain times of disclosure of the assumptions and the information bases on which critical judgements and estimates are made.
‘Out of the frying pan and into the fire’ – an unfortunate expression in the circumstances we are in, but it is used here to remind us that those aspects of reporting which were highlighted at the beginning of the pandemic continue to be valid concerns, if for new and different reasons. We remind you of our FRB articles in April and May 2020, and our series of publications on accounting considerations related to the Coronavirus 2019 disease.
The Russia/Ukraine war is increasingly affecting economic and global financial markets and exacerbating ongoing economic challenges, including issues such as rising inflation and global supply-chain disruption. Because of its broader impact on these macroeconomic conditions, many entities globally may need to consider the effect of the war on certain accounting and financial reporting matters. Our publication ‘Financial Reporting Considerations related to the Russia-Ukraine War’ provides insight into these considerations.
Sustainability – Demand for Improved Reporting
We are challenged by new horrors in the past couple of years, which were probably beyond the imagination of most before that. While that may be so, we humans should not and probably by now could not lose sight of the trouble we had created before that, and continue to create, with regard to climate change and other challenges to sustainability. While financial reporting has been substantially developed for some time, this has been less true of sustainability reporting with many global organisations having an input into what has been a fragmented hotch-potch of non-mandatory standards and guidance. The world, and in particular the investment community, have increasingly cried out for a comprehensive corporate reporting framework, to include both financial and sustainability reporting on a globally consistent and comparable basis.
It appears that the outcry is being listened to at a global level, with the creation of the International Sustainability Standards Board (ISSB) in November 2021, and at a more local European level, work in progress by the European Commission (EC) and its support organisation, the European Financial Reporting Advisory Group (EFRAG).
ISSB – Global Baseline
The ISSB has been created as a sister organisation of the International Accounting Standards Board (IASB) under the oversight and governance of the IFRS Foundation. Its primary objective is to develop a global baseline of sustainability standards to achieve global consistency and comparability of sustainability reporting. They will help to enable regional standard setters to develop standards consistently which may possibly be prescribed as mandatory for entities within the regions. The ISSB and the IASB will work together to develop a comprehensive corporate reporting framework. The ISSB will consolidate the various global organisations that have been engaged in developing sustainability in recent years. The Climate Disclosure Standards Board (CDSB) has already been consolidated. The Value Reporting Foundation (VRF), which was formed in 2021 from a merger of the Sustainability Accounting Standards Board (SASB) and the Integrated Reporting Council (IRC), is committed to being consolidated by June 2022. The ISSB is currently working on its own structural and governance frameworks, including the appointment of Board members. It is in the throes of developing standards, taking on board the recommendations of the specially appointed Technical Review Working Group. In our FRB article in January we wrote about the work of the TRWG in providing a running start to the ISSB in developing a global baseline of sustainability standards. On 31st March, the ISSB published the exposure drafts of standards on ‘Climate-related Disclosures’ and ‘General Requirements for Disclosure of Sustainability-related Financial Information’. This work will extend over the next couple of years.
Developments in Europe
Europe is making rapid progress, jump-started in April 2021 by the adoption by the EC of a proposal for a Corporate Sustainability Reporting Directive (CSRD) which would amend the existing reporting requirements of the European Non-Financial Reporting Directive (NFRD).
The proposed CSRD:
- Extends the scope to all large companies and entities listed on regulated markets, with some minor exceptions – more than 49,000 companies, compared with 11,000 under NFRD;
- Introduces some detailed reporting requirements, and a requirement to report in accordance with mandatory EU sustainability standards;
- Requires the audit (assurance) of reported information;
- Requires the tagging of information in accordance with the EU Taxonomy.
Parallel to the CSRD is the work being carried out by EFRAG on the development of draft European sustainability standards. EFRAG has put in place a structure which is equivalent to that of the IFRS Council, with separate Boards for both financial reporting and sustainability reporting and a recently appointed administrative board responsible for oversight and governance and for ensuring connectivity between both Boards.
Development of EU Standards
Under the control of EFRAG, a purpose driven Project Task Force has been appointed to develop European Sustainability Reporting Standards (ESRS). The PTF – ESRS has in the first quarter of 2022 published six batches of working papers which, in effect, are the first drafts of sustainability standards in individual areas. The working papers are not open to public consultation at this stage, but they will lead to exposure drafts on which consultation will be open.
The working papers also include information on the proposed architecture of the standards, with an appendix outlining the ESRS. The ESRS as proposed will include standards on:
- Strategy, governance, impacts, risks and opportunities – 5 components
- Sector-agnostic standards – environment, social and governance – 15 components
- Sector-specific – classification
- Conceptual guidelines – 6 components, with 4 not yet published
Possibly of most immediate interest is climate change, and the publication of the working paper draft of ESRS-E1: Climate Change will illuminate the direction that a future European standard may be expected to take.
ESRS – E1 is an elaboration into a draft standard with accompanying material, of the prototype and preliminary basis for conclusions which were published by EFRAG during 2021. All are consistent with the stated objective in the draft CSRD that information will be disclosed on climate change mitigation and climate change adaptation. The working paper covers both and also deals with ‘energy’ matters.
The objective of ESRS-E1 is to specify disclosure requirements which will enable users of the sustainability reporting standards to understand:
- The impact of the undertaking on climate change and its past, current, and future mitigation efforts in line with the Paris Agreement and limiting global warming to 1.5°C;
- The plans and capacity of the undertaking to adapt its business model(s) and operations in line with the transition to a sustainable economy and to contribute to limiting global warming to 1.5°C;
- The nature, type and extent of climate-related risks and opportunities to which the undertaking is exposed;
- The effect of climate-related risks and opportunities of the undertaking on existing assets and liabilities and the ability to generate future cash-flows and therefore to create enterprise value in the short, medium and long-term.
It is primarily from the perspective and for the reporting purpose of non-financial undertakings. Financial undertakings shall apply the standard, when published, but it must be in the context of specific regulatory and other sector-specific disclosure requirements. The main impacts, risks and opportunities for the financial sector are indirect via their portfolio of financial products and services.
ESRS -E1 specifies twenty-three different disclosure requirements, including four optional requirements.
The first of the disclosures specifies requirements in relation to the transition plan to align with the Paris Agreement. The undertaking shall disclose its plans to ensure that its business model and strategy are compatible with the transition to a climate-neutral economy and with limiting global warming to 1.5 °C in line with the Paris Agreement.
The disclosure required shall include:
(a) by reference to the short medium- and long-term targets to reduce Green-house Gas (GHG) emissions in own operations and along the value chain, an explanation of their alignment with limiting global warming to 1.5°C;
(b) by reference to GHG reduction targets and the climate change mitigation action plan, an explanation of the decarbonisation levers identified and key actions planned, including the adoption of new technologies;
(c) an explanation of the financial resources supporting the implementation of the transition plan;
(d) explanation of the locked-in GHG emissions from key assets and products, including a discussion about if and how these can jeopardise the achievement of GHG emission reduction targets and drive transition risk, and the plans to manage GHG and energy-intensive assets and products;
(e) an explanation of the role of aligning its economic activities with EU taxonomy and other regulations for its transition to a climate-neutral economy, including the plans for future Taxonomy-alignment;
(f) an explanation of how the transition plan is embedded in and aligned with its overall business strategy;
(g) an explanation of the progress made in implementing the transition plan, together with the resilience of the strategy and business model to principal climate-related transition and physical risks.
The above provides clear indication of the level of detail that will be required throughout the disclosures.
Additional performance measures deemed relevant for the future enhancement of the climate standard are presented as part of the Basis for Conclusions although they have not been prioritised for this standard. They relate to energy intensity, use of green hydrogen, breakdowns of GHG emissions and breakdowns of GHG intensity.
The EC timetable requires EFRAG to submit drafts by 30 June 2022. While this may seem a difficult timescale, the demand and momentum to meet that demand is of such intensity that it is most likely that targets will be achieved.
Time, resources and expertise will need to be committed to being prepared to generate information required to draft the required disclosures. Investors and other stakeholders may be expected to take a dim view of those entities that are not sufficiently prepared for implementation.
Monthly Reporting Pack - March 2022
Irish/UK GAAP & Related Developments
IFRS & Related Developments